Equity Index Basis
Basis is the difference in price between the futures contract and the spot index value. We generally quote Equity Index futures basis as the futures price minus the spot index value.
Why does basis matter?
Basis matters because Equity Index futures are not an asset. They do not convey the same rights of ownership and income possibilities that an index of physical shares of stock possess.
Consequently, equity index futures cannot be expected to trade at the same price level as the spot or cash value of the associated stock index.
About Cost of Carry
The basis of an equity index futures contract versus its underlying spot index may be positive or negative, depending on dividend income and financing cost rates.
To fully understand the basis, it is necessary to understand something called cost of carry. There are a number of costs associated with having an investment position. Factors may include financial costs, such as interest, and economic costs, such as opportunity costs.
As previously mentioned, because Equity Index futures are not an asset, they don’t convey any rights of ownership, such as receiving dividend payments. However, the financial value, or opportunity cost, of those dividends is accounted for in the price of the Equity Index futures contract.
When short-term interest rates (represented by finance charges) are lower than the dividend yields on the spot index, the cost of carry is said to be positive.
If current short-term rates are at 0.65% and the dividend yield on the S&P 500 index is roughly 2.00%, the cost of carry would be positive.
This is because the dividend income stream at 2.00% would be greater than the cost of finance at 0.65%. The futures price must reflect this economic reality by discounting in price versus the spot index.
Say that on a given day, E-mini S&P 500 futures for expiration in September 2016 (ESU6) were quoted at a price of 2187.75 while simultaneously the S&P 500 spot index was quoted at 2188.51 points. The difference (2187.75 – 2188.51 = negative 0.76 index points) is the basis. The futures are trading at a discount to spot. This is due to positive carry.
The price spread, or basis, between futures and spot includes a function of the time value of money. That is, the value of the dividend income discount gets smaller and smaller as the contract approaches expiration. It disappears entirely as futures and spot settle to the same figure.
Basis is the price difference between cash (spot) and futures price.
In the case of equity index products, there is a cost of carry consideration that determines whether the futures price trades at a discount or a premium to spot.
Finally, be aware that the basis valuation is the result of the finance charges versus the dividend income. It will be different depending on the index or sector futures contract under consideration.
Peter Knight Advisor